Commercial leases are popular both for some inherent advantages over asset purchases and for tax benefits in U.S. and some other jurisdictions. Many companies and business owners may prefer leasing, rather than purchasing, because leasing is typically less capital-intensive, less risky (in terms of value fluctuations of capital assets), and more flexible. Almost all companies enter into real estate leases to rent office, production, and/or storage spaces. Many companies, such as commercial airlines, automobile manufacturers and construction contractors, routinely rent expensive equipment through long-term leases. Apart from a profitable rate of return, leases may also provide lessors significant tax benefits, such as depreciation deductions and investment credits, which can be shared with lessees to some extent (e.g., through lower lease payments). In fact, in order to reap the tax benefits of an asset lease, a lessor may borrow from a lender most of the funds needed to purchase an asset (e.g., an airliner or heavy machinery) and then lease it to a lessee, wherein the lender is given a senior secured interest on the asset as well as an assignment of the lease and lease payments. Such a lease is known as a leveraged lease, and the lessor is referred to as an equity owner or an equity participant in the lease. While an equity owner does not profit much from lease payments in a leveraged lease, the equity owner may still enjoy a substantial tax benefit.
Lessors or equity owners in commercial leases may operate under a significant risk of lessee default. Unexpected credit events, such as bankruptcy, insolvency, or restructuring of a lessee entity, may cause it to default on a lease. A lessee default will not only deprive the lessor of its income stream of lease payments, but may also put the recovery of the leased asset at risk. In addition, some or all of the tax benefits that the lessor derives from the lease may be rolled back or otherwise lost.
A lessor's risks in the context of bankruptcy or reorganization of a lessee entity are greater than the risks faced by the lessee's other bankruptcy creditors at least under U.S. bankruptcy law. While the lessor (or lease creditor) can pursue a claim against the defaulting lessee in bankruptcy proceedings, such a claim is an unsecured debt which is subordinate to other senior debts which the lessee must satisfy first. The lessee's other senior creditors may include, for example, bondholders, pension plan beneficiaries, secured creditors (mortgagees), and trade receivable creditors (i.e., those owed monies for goods or services already delivered). The status of a lease creditor can be further disadvantaged by the fact that a bankrupt lessee, as part of its restructuring efforts, could reject the lease agreement.
Few risk management options are currently available to lessors. A lessor may try to avoid risky leases by carefully evaluating and monitoring the credit-worthiness of potential lessees or tenants. However, credit-screening and credit-monitoring can be time-consuming and only gauge risks (often imprecisely) as opposed to actually hedging risks. None of the existing risk-hedging tools, such as credit default swap (CDS) contracts, insurance policies, and third-party guarantees, can provide a satisfactory solution that is simply, flexible, and generally available at a reasonable cost.
For example, CDS contracts typically have minimum terms of 1, 3, or 5 years and are only available with respect to lessee companies with sufficient liquidity. A CDS contract typically has a fixed notional amount which does not adjust for the changing nature of risk exposure in a lease. As a result, a CDS hedge for lease risks will almost always prove to be over-hedging or under-hedging. In addition, a CDS contract requires actual settlement with a delivery of lessee's bonds, which is cumbersome and inefficient for implementing the hedge. Therefore, CDS contracts are not amenable to asset leases.
While lease insurance policies are relatively inexpensive for some companies, they tend to be unavailable to distressed or underperforming companies. The underwriting process for a lease insurance policy can be quite long, and so is the claims process which may include a long waiting period. Insurance providers may contest lessors' claims and as a result further delay compensation of lessors' financial losses. Furthermore, instead of receiving a full coverage, the insured may be obligated to pay a 10-20% deductible or co-insurance.
In some cases, a lessor might be able to demand from a lessee some kind of third-party guarantee before entering into a lease agreement. For example, an affiliated entity of the lessee may guarantee lease payments, or a bank may issue a letter of credit on the lessee's behalf. However, such third-party guarantors are not always available, and, in lease negotiations, lessors are not always in a strong bargaining position to insist on third-party guarantees. Furthermore, it may be a complicated and protracted process for a lessor to pursue its claims against a third party after a lessee defaults.
JPMorgan Chase Bank has previously implemented a risk-hedging product known as “account receivables put,” whereby a seller in a supply contract may transfer to the bank a claim against a defaulting buyer for outstanding receivables. This product typically applies only to the seller's risk of losing account receivables (owed for goods/services already delivered to buyer). However, the account receivables put is not adaptable to commercial leases since it is not designed to cover losses resulting from lease defaults, such as losses of future lease payments, residual values of leased assets, or lease-specific tax benefits.
In view of the foregoing, it may be understood that there are significant problems and shortcomings associated with current technologies of risk management.